Fibonacci – either to-do or voodoo

Philip Salter
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FAMED for introducing the Hindu-Arabic positional number system to Europe, Leonardo Fibonacci was one of the greatest mathematicians of his day (c.1170-c.1250) and 80 years is not a bad spread for the Middle Ages. He didn’t discover Fibonacci numbers, but in Liber Abaci he enlightened Europeans on this Indian intellectual innovation. He explained Fibonacci numbers by asking, under contrived circumstances, how many pairs of rabbits are created by one pair of rabbits in one year? The following numbers are revealed: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 etc. A Fibonacci sequence is also simply the sum of the two previous numbers in the chain. Fascinatingly, nature is laced though with Fibonacci patterns – in seashells, branches and stems, in the heads of sunflowers, flowering artichokes, and the patterns of pineapples and pinecones.

Each step in the Fibonacci moves us closer to what is called the golden ratio – approximately 1.618, and from this the Fibonacci ratios, beloved by some traders for plotting Fibonacci retracements, are worked out:

● 0.618 (or 61.8 per cent): the reciprocal of the golden ratio.

● 0.50 (or 50 per cent): the second number divided by the third (1 divided by 2).

● 0.382 (or 38.2 per cent): the reciprocal of the golden ratio squared (i.e. 89 / 233).

● 0.236 (or 23.6 per cent): the reciprocal of the golden ratio cubed (i.e. 55 / 233).

Some traders plot these Fibonacci retracements on charts to try to predict levels of support and resistance based on previous highs and lows (see, right).

Here we ask two experts for their thoughts on this tool of technical analysis. One a proponent of the use, the other a detractor of the abuse, of Fibonacci retracements.

ONE of the greatest challenges and dilemmas for any trader when contemplating a trade is where is the best possible entry point, exit point and where to place a stop loss. This can take years of practice, tests and learning from mistakes and even then it can still be a challenge. This is one of the reasons why most traders these days turn to technical analysis to aid their decision making, with Fibonacci retracements being one of the most popular.

Of course sceptics will say that technical analysis methods, such as Fibonaccis, just become self-fulfilling prophecies. That is, as so many traders tend to trade the same patterns then the chances of a reversal happening at a certain point increases. But there-in also lies the opportunities for traders.

When you place a trade you should always be looking for a trade with the probabilities in your favour, and you should always look at the bigger picture. So try to find a significant Fibonacci level that a price is approaching, look for other supporting indicators – such as a hinging relative strength index (RSI) or stochastic – and then place your trade.

When placing a trade, look for a Fibonacci level above or below which you could place your stop losses, to put the probabilities of it surviving on your side. Remember, if everyone is looking to sell at a Fibonacci level, the resistance will be strong.

Conversely, if you are a momentum trader, look to go long as a price breaks through a Fibonacci level, as stop losses and momentum buyers can often accelerate the move in your favour.

You only need to look at recent movements in gold to see a big picture Fibonacci move (see graph above, left), with the rebound from the September slide being held repeatedly by the 38.2 per cent Fibonacci level at $1,680. Selling here would have yielded multiple profitable trades. Then, when it broke through, it reached the 50 per cent level of $1,735 in just two days, where it offered support. The 61.8 per cent level was almost reached on Friday at $1,772. The dip to the 50 per cent level on 2 November was a great case for supporting evidence for the trade, with the moving average convergence-divergence (MACD) crossing to the upside and also support being offered from the 100-day moving average.

And even on Friday, a beautiful trade in euro-dollar was possible (see graph above, middle) by selling around $1.3833, the 38.2 per cent Fibonacci of the April to September fall (orange line), plus the 38.2 per cent Fibonacci of last week’s highs to Monday’s lows at $1.3852 (blue line). Also check out the high on 27 October, with an overbought RSI.

So, the advice is look at Fibonaccis – they can be powerful aids to help decision making and position planning. But remember, no one tool is the golden ticket and they can be blown out of the water by significant economic news or developments.

ONE of my favourite ranting topics is the tendency among those of us who use technical analysis to make this approach to markets much more complicated than it really needs to be.

I am all in favour of a pragmatic approach to markets. Ultimately the name of the game is making money, so if that is the end result of whatever analysis technique then more power to your elbow, but I think lots of people make life more difficult than it has to be.

The various Fibonacci techniques are a great case in point – I can remember (sadly) many, many hours spent in the early days of my career figuring out how to apply this almost mystical set of numbers to the markets.

I think the reason that the more complicated and esoteric approaches appeal is because of the belief amongst many in the beginning that there is some sort of hidden magic system to the markets and if this can only be found then an abundance of Lamborghinis will result.

One of the problems I have with Fibonacci (and other approaches) is the idea that there is a hidden precise order to markets – and more so the over complication that it implies.

Ultimately, markets can do one of three things – up, down or sideways. I am a big fan of keeping it simple, looking at big levels in the markets to identify trading opportunities and/or following trends.

There is a great example of this approach in the FTSE last week (see graph above, right) – despite the Greek inspired turmoil, once again the FTSE buyers returned ahead of what had been a major level for the FTSE in October, 5,330. Weakness back to here had proved tempting in the past – and again last week it was a nice low risk, high reward potential trade. And not needing any hint of market voodoo to identify it.